Peru - Program Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 4206 PROJECT COMPLETION REPORT PERU: PROGRAM LOAN LOAN 1693-PE December 7, 1982 Latin America and the Caribbean Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   FOR OFFICIAL USE ONLY TABLE OF CONTENTS Page No. PREFACE BASIC DATA SHEET ii HIGHLIGHTS i I. BACKGROUND ...................................................... I 1. Introduction .... ........................ 1 2. Economic Background . ........................... . 1 II. HISTORY AND FEATURES OF THE LOAN ............... ...... 3 III. ECONOMIC PERFORMANCE AND IMPLEMENTATION OF THE ERP (1979-80) ....................................................... 4 1. Overall Performance . ......... . . .................. . 4 2. Implementation of Individual Measures ..* ........ 5 a. Opening up of the economy .. ................ 5 b. Export promotion ... ............. ........ 8 c. Strengthening of the tax system .. .......... 10 d. Interest'rate policy ....................... 11 e. Public investment program .................. 13 IV. EXECUTION OF THE LOAN ................................ 16 1. Loan Withdrawal .. .... . . . . . .............................. . 16 2. Use of Loan Proceeds ..o ..... ............oooo 16 3. Procurement . . . . . . . . . . . . . . . . .. ....o..o ... . o. . ..... . 18 4. Use of Counterpart Funds ...o..... ooo ........ 18 5. Technical Assistance .......... .. ......... 19 6. Health Component ...-oooooo-... ..........o.... 23 V. CONCLUSION ..oo...o ...................... oo....o .... ooo. .... o.o.. 24 ATTACHMENTS 1. Economic Recovery Progr-am ---(ERP) 26 2. Table 1: Allocationi'of ,Counterpart Funds to High ,P,r-iority Projects in the 1979 Investment Budget I> . 28 Table 2: Centr.al Bank Allocations (own funds) 30 Table 3:-.--1979-80 Public Fixed Investment by Sector 31 Table 4: L=a-rge Scal'e Investment Projects 32 3. Comments from the Borrower 33 Thi- document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   PROJECT COMPLETION REPORT PERU: PROGRAM LOAN (Loan No. 1693-PE) PREFACE 1. This is a project completion report (PCR) for the US$115 million Peru Program Loan (No. 1693-PE of May 1979). The loan was closed, fully disbursed, in July 1981. 2. The PCR was prepared by the Latin America and the Caribbean Regional Office based on information from Bank Group files in Washington, the reports of supervision missions, and a project completion report prepared by the Central Reserve Bank of Peru, which was responsible for project execution. 3. Copies of the PCR were sent to the Borrower; the comments received have been reflected in the PCR and are contained in Attachment 3. 4. The project has not been subjected to audit by the Operations Evaluation Department.   - ii - BASIC DATA SHEET KEY PROJECT DATA Actual or Actual as % Appraisal revised of appraisal estimate estimate estimate Project costs (US$ million) N.A. N.A. -- Loan amount (US$ million) 115.0 115.0 100 Date Board approval 05/01/79 05/01/79 Date of Effectiveness 07/17/79 05/24/79 Date components completed 01/31/80 06/01/81 Closing Date 06/30/80 12/31/80 Economic rate of return (%) N.A N.A. CUMMULATIVE DISBURSEMENTS FY79 FY80 FY81 Appraisal estimate (US$ million) 115.0 - Actual (US$ million) 109.6 5.4 - Actual as % of estimate 95.3 100 Date of final disbursement 7/81 MISSION DATA No. of Man-days Specializations Mission Date persons in field represented a/ Identification 6/78 4 96 E, IE, LO, PDS Preparation 1 9/78 3 33 E, IE, LO Preparation 2 11/78 3 24 E, IE, LO Appraisal 12/78 5 95 E, IE, LO, YP, RA Supervision 1 7/79 3 12 E, IE, LO Supervision 2 11/79 3 27 E, IE, LO Supervision 3 2/80 3 21 E, IE, LO Subtotal 24 308 OTHER PROJECT DATA Borrower: Republic of Peru Executing Agency: Central Reserve Bank of Peru Fiscal Year: July 1 - June 30 Name of currency (abbreviation): Sol (S/.) Currency Exchange Rate Appraisal year-average: 1978 US$1.00 = S/. 160.0 Intervening years average: 1979-80 US$1.00 = S/. 256.4 Completion year aver-raze: 1981 US$1.00 = S/. 426.6 Follow on Project None a/ E - Economist, IE - Industrial Economist, LO - Loan Officer, PDS - Public Debt Specialist, YP - Young Professional, RA - Research Assistant.   - iii - PROJECT COMPLETION REPORT PERU: PROGRAM LOAN (Loan No. 1693-PE) HIGHLIGHTS 1. The Program Loan was conceived in 1978, at a time when Peru faced a severe financial crisis and was close to default on its public foreign debt. It was designed to provide rapidly disbursing foreign exchange to help finance priority imports--primarily capital goods and industrial imports--as well as technical assistance. The loan supported an Economic Recovery Program (ERP) developed by the Government with intensive cooperation from the Bank, which was designed to stimulate economic growth and improve the efficiency of resource use in the medium term. The ERP was one element of a package of measures, including an IMF standby and debt rescheduling which were designed to restore financial stability and economic growth. This package, together with price increases for Peru's major export products in 1979 was successful in accomplishing these objectives. 2. The ERP included major policy changes in such critical areas as import liberalization, export promotion, exchange rate policy, interest rate policy, tax administration, and reorientation of public investment. These changes were achieved to a high degree, particularly in the trade area (import liberalization, export promotion). Beyond the immediate and measurable results, the Program Loan provided the Bank with an excellent opportunity for a far-reaching and frank policy dialogue, which covered a broad spectrum of policy isues. This dialogue--based on periodic monitoring of economic performance--has continued with the Belaunde Administration and has created an atmosphere of mutual trust. The opening of the Bank's resident mission in December 1979 has also had a major positive impact. 3. As spelled out in the report, the Loan was less successful in some other areas as pricing and interest rate policies, and the impact on the public investment program was also limited. However, based on the continued policy dialogue, progress has been made in these fields after the formal completion of the Program Loan. Major upward adjustments of prices for publicly supplied goods and services have been implemented at regular intervals, the interest rate structure was revised and substantially raised, and the Bank's involvement in public investment planning through the May 1981 Consultative Group and through Bank staff participation in recent IMF missions is showing more positive results, i.e. some proposed major projects of doubtful economic justification have been held in abeyance pending the results of additional studies. 4. The technical assistance and health components were also largely successful. The technical assistance was instrumental in engineering the import liberalization process and in the reformulation of the Bayovar phosphate project; it also made a major contribution to the Government's  - iv - thinking process on public investment through the study of selected projects and the preparation of the 1981-85 investment program. The purchase of drugs, vaccines, and insecticides under the health component also reaped measurable positive results in some areas, which was particularly important during a time of economic stabilization with substantially reduced public health expenditures and rising incidence of communicable diseases and infant mortality.  - 1 - I. BACKGROUND 1. Introduction 1. On May 17, 1979, the Bank signed a $115 million Program Loan with the Republic of Peru which had been approved by the Board on May 1. The loan was designed to help meet foreign exchange requirements for high priority imports and technical assistance in support of the Government's Economic Recovery Program (ERP) -- a comprehensive package of short-term and structural economic policy measures. 2. Disbursement of the loan was completed on July 15, 1981. Over 95 percent of the loan, however, had been disbursed by June 30, 1980, the original closing date (For details see para. 48). Three supervision missions visited Peru to determine whether progress under the ERP was satisfactory, as a basis for release of loan tranches. Information gathered by these and other missions as well as the views expressed in Government reports on the loan and the ERP are reflected in this completion report. 2. Economic Background 3. The President's Report (No. P-2504-PE, dated April 9, 1979) analyzed the causes of the economic crisis that Peru experienced during 1977-78. The crisis was mainly the result of expansionary fiscal and monetary policies, but was exacerbated by a deterioration in the country's terms of trade by nearly 30 percent during the 1974-78 period. Up to 1977, the military Government increased public sector spending rapidly, including large outlays for non developmental expenditures. The growth in expenditures was not matched by corresponding efforts to mobilize resources with the result that the public sector deficit increased sharply from 0.8 percent of GDP in 1970 to 9.2 percent in 1977. Moreover, the pricing, interest rate, and exchange rate policies followed up to 1976 discouraged savings, exports and -- at times -- overall production. 4. Public sector savings dropped steadily from 4.6 percent of GDP in 1970 to a negative level of 3.1 percent in 1977. Major causes were (i) the rising cost of food and petroleum subsidies; (ii) an increased interest burden from the growing domestic and foreign debt; (iii) high defense outlays; and (iv) the erosion of the tax base because of excessive tax exemptions and weak tax administration. At the same time, public investment increased from 5.4 percent of GDP in 1970 to 8.4 percent in 1975. A substantial portion of it went to large-scale projects -- many with long gestation periods -- which contributed little to output and employment growth. 5. The impact of this fiscal policy was exacerbated by negative real interest rates and an increasingly overvalued exchange rate which discouraged domestic financial savings and triggered massive capital flight. Excess demand was reflected in accelerating inflation (from 6 percent in 1970 to 38 percent in 1977) and increasing current account deficits in the balance of payments (equivalent to 10 percent of GDP in 1975). To finance these  -2- deficits, Peru incurred additional external debt. The debt, totaling $8.3 billion at year-end 1977 (including private sector and short-term debt), was contracted on relatively short maturities; three-fourths of the public sector debt of $4.7 billion was scheduled to be repaid during 1978-82. 6. Beginning in 1975, successive economic teams attempted to cope with the mounting economic difficulties without, however, lasting success. By mid-1978, the crisis had entered an acute stage with inflation approaching 100 percent on an annual basis, depressed production levels, and high negative international reserves. The private sector had increasing difficulties in opening letters of credit for current imports, and the public sector was approaching a situation where it would have been unable to fully service its external debt. 7. In May 1978, a new economic team embarked on a comprehensive stabilization program that was relatively successful in turning Peru's economic and financial situation around. The program consisted of the adoption of a crawling peg (resulting in the devaluation of the sol from S/.130 per US$1 in May to about S/.200 by year-end 1978), a plan to eliminate subsidies and relax price controls gradually, the implementation of tax measures, a reduction in Government expenditures, an increase in interest rates and the restructuring of the bulk of the public external debt due in 1979 and 1980 by a 1978 Paris Club meeting. This program was supported by a standby arrangement with the IMF. 8. The financial stabilization program dealt primarily with the short-term problem of stabilization; it was complemented by an Economic Recovery Program (ERP), which was supported by the Bank's program loan. This program was designed to stimulate economic growth and improve the efficiency of resource use in the medium term, and included such measures as opening up the economy, promoting non-traditional exports, and improving public investment. It addressed some of the country's critical structural problems, particularly in the areas of industrial policy, export promotion, tax administration, and public investment (see Section III and Attachment 1). 9. The Belaunde administration that took office in July 1980 has continued efforts started under the ERP by accelerating trade liberalization, including elimination of most non-tariff barriers and cuts in tariffs, by adopting more adequate foreign exchange, interest rate, and pricing policies and by attempting to further improve the quality of public investment. The Bank was involved in the design of some of these policy actions through our ongoing frank policy dialogue which began during the preparation of the Program Loan.  - 3 - II. HISTORY AND FEATURES OF THE LOAN 10. The Program Loan was developed through intensive cooperation between the Government and the Bank that began in June 1978. After a series of preparation missions, the loan was appraised in December 1978 and negotiated at the end of March 1979. 11. The Government had requested consideration of a program loan by the Bank in view of the country's critical financial and economic situation and as a support for its far-reaching policy changes. The loan financed essen- tial imports and technical assistance in economic policy design and implemen- tation and was an important element in the Government's stabilization and debt restructuring campaign. Its principal policy objective, however, was to support the ERP. The components of the ERP are summarized in para. 8 and described in more detail in Attachment 1. The development of the Program Loan was an effective vehicle for a far-reaching economic policy dialogue with the Government in connection with the country's economic reactivation efforts. Although Peru's balance of payments situation had begun to improve by the time the loan was presented for Bank approval, the weak reserve position and still high external debt, the difficult fiscal situation, high unemployment, as well as the need to provide support to the economic author- ities in their efforts to implement the ERP caused the Bank to proceed with the Program Loan. In particular, the Program loan was a vehicle for periodic monitoring and a continuous frank policy dialogue through the three supervi- sion missions. The still ongoing intensive dialogue, which has enabled the Bank to have a significant influence on Government policy, is one of the Program Loan's main achievements. The opening of the Bank's Lima office has also played a major role in the continued dialogue (and in the improvement of Bank operations in general). 12. Apart from the intensive dialogue with the Peruvian Government, there was extensive interaction between the Bank and the IMF during all phases of preparation of the Program Loan and the 1978 Stand-by Arrangement, respectively. The exchange of views led to some modifications in the IMF program, particularly with regard to public investment outlays. 13. The $115 million Program Loan was allocated: (i) $95 million for the importation of inputs for the industrial sector; (ii) $19.9 million for other imports; and (iii) $100,000 for ERP related technical assistance. The loan was divided in four tranches. A $40 million first tranche was available immediately after loan effectivenes. Thereafter, if the progress reviews scheduled for July 15, 1979, October 15, 1979 and January 15, 1980 indicated that the execution of the ERP was satisfactory, three tranches of $30, $30 and $15 million, respectively would be available for disbursement. The counterpart funds, which were to be generated through the private sector's purchase of foreign exchange to pay for its imports, were to be used for the financing of local expenditures related to high priority public investment projects specified in the Loan Agreement.  - 4 - 14. The next section of this report deals with the economic performance under the ERP and the implementation of specific policy measures related to the ERP. Section IV deals with the operational aspects of the Program Loan, including the technical assistance component and the use of the loan proceeds and counterpart funds. III. ECONOMIC PERFORMANCE AND IMPLEMENTATION OF THE ERP (1979-80) 1. Overall Performance 15. This section is based on the findings of the supervision missions, as well as other economic missions. In general terms, the implementation implementation of the stabilization program and the ERP - facilitated by increased petroleum exports and improved terms of trade -- was successful in turning the financial situation around and in stimulating economic growth. There was a strong balance of payments performance in 1979 and 1980, and the public finance situation was also greatly improved, at least during 1979. Key performance indicators are shown in Table 1. Table 1: SELECTED FINANCIAL AND ECONOMIC INDICATORS, PERU, 1977-1980 1977 1978 1979 1980 Net international reserves of the banking system (US$ million) -1,100.9 -1,025.0 553.9 1,285.1 Gross international reserves of the banking system (US$ million) 457.4 592.4 1,858.2 2,556.4 (equivalent to .. months of imports of goods and non-factor services) (2.0) (3.4) (8.5) (7.8) Medium- and long-term external debt (in % of GDP) 44.4 56.8 49.0 40.5 of which: public debt 34.5 45.6 40.1 33.4 Public debt-service ratio (in % of exports of foods and non-factor services) 30.6 31.2 22.6 a/ 31.3 a/ Overall public sector deficit (in % of GDP) 9.2 5.7 1.7 5.9 Domestic credit expansion to the public sector (in % of GDP) 3.1 3.8 0.7 2.5 Savings-Investment gap (GNS-GDI in % of GNP) -7.5 -2.0 3.8 1.6 GDP growth, real (%) - Overall 0.0 -0.7 3.4 3.1 - Per capita -2.6 -3.3 0.7 0.4 Export growth, real (%) 11.6 14.2 12.3 -5.6 Import growth, real (%) 0.3 -30.2 11.2 44.0 Inflation Lima CPI (annual percentage change) 38.0 57.8 67.7 59.2 GDP deflator (annual percentage change) 37.7 63.3 73.1 57.9 a/ Net of refinancing. Source: Bank Economic Report No. 3438-PE of 4/27/81.  -5- 16. The ERP was most successful in opening up the economy and boosting non-traditional exports, mainly manufactured goods. The elimination of non-tariff barriers, the setting up of a new tariff system, and eventually further tariff cuts were implemented faster than expected and quickly began to show some price dampening effects through increased competition from imports. Non-traditional exports grew at an unprecedented rate in 1979 and, after elimination of some distortions in the tax credit scheme (CERTEX), continued to expand in 1980, although at a reduced pace. This growth was mostly the result of a more adequate, export-oriented exchange rate policy, generous export subsidies -- mostly in the form of tax credit certificates (CERTEX) - and the depressed state of the domestic market. There was also progress in strengthening tax administration, although the measures were mostly geared to short-term improvements and did not address the need for structural changes. In the area of public investment, project execution was accelerated, particularly in 1980, and investment priorities began to change to better address the country's needs. Progress in pricing and interest rate policies was modest through 1980, mainly because of the Government's fear that more vigorous price and interest rate adjustments would further fuel inflation. Major changes in the areas of pricing and interest rates occurred at the beginning of 1981, following up on the initiatives started under the ERP, but after the closing date of the Program Loan. 17. In July 1980, at the time of transition from the military to the civilian democratically-elected Government, the Central Bank of Peru published a paper summarizing the experience with the stabilization and economic recovery programs.1/ The paper presents a balanced account of achievements and difficulties encountered. It concentrates on the description of demand management, debt rescheduling, and selective stimulation of economic activities through specific credit programs. While it also makes reference to measures undertaken under the ERP as described in para. 8, it was too early to assess some of the structural changes having been undertaken under the ERP, and the report thus concentrates on the evaluation of the aforementioned actions. Without the benefit of a full evaluation of the implementation of the ERP and the supporting Program Loan by the Peruvian authorities, the implementation of the different elements of the ERP is described and assessed in the following sub-section based on information provided by the Central Bank of Peru (which are all available in Division files). 2. Implementation of Individual Measures A. Opening up of the Economy 18. According to the Loan Agreement (Schedule 5), the Government was committed to a staged import liberalization process consisting of the following measures: 1/ Reflexiones en Torno a un Programa de Estabilizacion. La Experiencia Peruana 1978-1980, Julio 1980. (Available in Division files).  6 - gradual elimination of the different lists of import restrictions to be completed in several steps by end-1980; simultaneously, gradual broadening of the list of permitted imports and automatic granting of import licenses for these products; enactment of a new import tariff law in line with the Andean Pact's guidelines by July 1979 and gradual implementation of its provisions by December 1983; and gradual elimination of tariff exemptions to be completed by December 1980. 19. The import liberalization process agreed upon during preparation of the Program Loan started before loan approval with the elimination of the National Register of Manufactures (RNM) on March 7, 1979. The RNM provided virtually unlimited protection by effectively banning imports competing with locally manufactured products. It was replaced by a system of temporary and permanent import prohibitions and a series of restrictions subjecting imports to prior approval. In March 1979, the situation of import restrictions was as follows: Table 2: IMPORT RESTRICTIONS PERU, MARCH 1979 Import System Number of Items Permitted imports 2,430 Restricted imports, subject to approval 499 Temporarily prohibited imports 539 Permanently prohibited imports 1,175 T O T A L 4,643 Source: Central Bank 20. Starting from this basis in March 1979, the import liberalization process advanced gradually through 1979 and 1980 -- initially somewhat more slowly than expected and with temporary setbacks, but then at a considerably faster pace during the second and third quarters of 1980. A new import tariff law was enacted in August 1979. It consolidated and unified the tariff system, establishing a set of ad valorem tariffs to be uniformly applied to all customs items on the basis of CIF import values. The maximum tariff was reduced from 355 to 155 percent, the unweighted average from 66 to 39 percent. In September 1980, tariffs were reduced further establishing a maximum of 60 percent and lowering the unweighted average to 35 percent. Further minor cuts were made in April 1981.  - 7 - 21. The first modification in import regulations was made in December 1979. While the list of permitted imports was greatly expanded and import prohibitions almost completely eliminated, the list of imports subject to prior approval was also expanded, which in practice meant a continuation of the effective ban on imports competing with local production. During 1980, however, the list of imports subject to prior approval was gradually reduced. Finally in September 1980, import licenses, which had created administrative obstacles to a rapid flow of imports, were abolished except for a small list of restricted imports. Changes in import regulations are summarized in the following table: Table 3: IMPORT SYSTEM, PERU 1979-1980 Number of Customs Items Import System 3/31/79 12/31/79 12/31/80 Permitted imports 2,430 3,997 4,979 Imports subject to approval 499 1,026 117 Temporarily prohibited imports 529 - - Permanently prohibited imports 1,175 9 7 T 0 T A L S 4,643 5,023 5,103 Source: Central Bank In addition, administrative measures were taken to streamline licensing and customs clearance procedures and, more importantly, in March 1980 the import surcharge of 10 percent ad valorem, which had been introduced in 1970 for fiscal reasons, was eliminated. 22. The import liberalization process was effectively implemented and completed ahead of the agreed schedule. In some respects (e.g., lowering of tariffs), the accomplishments exceeded expectations. It was extremely difficult to implement these measures against the powerful lobbying of the industrial sector, many of whose members had a vested interest in continued high protection. Nevertheless, import restrictions were expeditiously dismantled during the second quarter of 1980 -- the final months of the military Government -- and with even more vigor during the third quarter of 1980, the initial period of the democratic Government. The dialogue between the Bank and the Government and the Bank's insistence on the importance of import liberalization for both increasing industrial efficiency and economic recovery was instrumental in accelerating the process during the final phase of the military Government. The continuation and completion of the process under the new Government, however, was almost exclusively the result of the persevering efforts of the Vice Minister of Commerce.  -8- B. Export Promotion 23. Specific measures to promote non-traditional exports such as a new export promotion law (enacted in November 1978 to consolidate and strengthen special incentives) and the pursuit of an adequate exchange rate policy had been implemented during or even before preparation of the Program Loan. The Loan Agreement, therefore, made only general reference to export promotion policies except for the exchange rate, which the Government committed itself to maintain about constant in real terms (Schedule 5 of the Loan Agreement). In addition, it had been agreed that the Central Bank would allocate the equivalent of $20 million to the Non-Traditional Export Fund (FENT) (Sections 5.01 (b) and 1.02 (n) of the Loan Agreement) and that -- if necessary -- another $15 million equivalent in counterpart funds converted to dollars would be made available to FENT if the Government so requested (Section 3.02 of the Loan Agreement) for the financing of export-related imports of raw materials or intermediate inputs. 24. The export tax credit scheme (CERTEX) and a more adequate exchange rate policy were the most powerful instruments that led to the increase in Peru's non-traditional exports from $221 million in 1977 to $752 million in 1980. The CERTEX, introduced in 1968 and adjusted in 1972, was substantially increased in 1976, and the 1978 Non-Traditional Export Promotion Law basically guaranteed the existing CERTEX scheme through 1988. While the reaction to the increase in CERTEX was positive, the sharp increase in non- traditional exports occurred only after substantial adjustments in the exchange rate during 1978 and 1979 and at the time domestic market demand was deteriorating. The devaluation of the sol and the movement of purchasing power parity are reported in Table 4. 25. While the system of mini-devaluation has been followed since 1978 and real parity has been maintained through mid-1979, the pace of devaluation slowed down somewhat in the second half of 1979 resulting in a gradual appre- ciation of the sol in real terms. The pace of devaluation was again accelerated in the last quarter of 1980 and the first quarter of 1981, basically in line with the differential between domestic and international inflation. Among the reasons that led the Government to slow down devalua- tion in late 1979 and 1980 was the concern about the impact on inflation and inflationary expectations. In view of the relatively high CERTEX rates, averaging 28 percent of the FOB value of eligible non-traditional exports, the gradual real appreciation of the sol still left the exporters with a sufficiently high incentive to export. The situation changed, however, in the first quarter of 1981 when, in an effort to eliminate abuses that had developed, the CERTEX was reduced by eight to ten percentage points, and the number of eligible products was restricted. 26. Up to December 1980, the CERTEX system remained basically unchanged. Only minor changes were made in early 1980 to eliminate the distortions and abuses. Rates were substantially reduced for a small number of products with extremely low value added by manufacture such as alpaca tops and silvers, gold jewelry, or ZAMAC, a zinc alloy. Major changes to rationalize the system and to make it a more effective instrument of promo- tion of non-traditional exports with high manufacturing content were imple- mented only in February 1981.  -9- 27. Export financing through FENT and export credit insurance have been important complements to the other export incentives.- The FENT was set up in 1972 by the Industrial Bank of Peru (BIP) to help finance the production and sale of non-traditional exports. Loans have been made either directly through BIP or by commercial banks, mostly for pre-shipment financing. In 1979, the Central Bank allocated $28.5 million to FENT; in 1980, the additional allocation amounted to $6.9 million. In addition, $3.5 million equivalent in counterpart funds generated from the proceeds of the Program Loan were channeled through BIP (see Attachment 2, Tables 1 and 2). Table 4: NOMINAL EXCHANGE RATE AND PURCHASING POWER PARITY OF THE SOL, 1978-80 Infla- Purchasing Actual Ex- Domestic U.S. In- tion Dif- Power Deviation change Rate Inflation flation2/ ferential Parity 3/ (5)-(1)(%) S/. per $ (%)1/ (x) (%) S/. per $ (1) (1) (2) (3) (4) (5) (6) I 130.30 - - - 132.7 1.8 1978 II 141.86 17.0 3.0 13.6 150.6 6.2 III 165.75 16.6 1.6 14.8 173.1 4.4 IV 187.43 11.4 2.2 9.0 188.6 0.6 I 203.37 13.7 3.6 9.1 205.8 1.2 1979 II 218.60 13.9 3.5 10.0 226.6 3.7 III 232.22 12.3 3.2 11.1 251.7 8.4 IV 244.01 14.2 3.5 7.8 271.4 11.2 I 257.29 12.9 4.6 7.9 292.8 13.8 1980 II 275.66 9.0 2.1 6.8 312.7 13.4 III 295.78 13.2 3.2 9.7 343.1 16.0 IV 325.89 14.8 2.1 12.4 385.6 18.3 1/ Quarterly changes of the LIMA CPI 2/ Quarterly changes of the U.S. WPI 3/ 1978 I estimate of the purchasing power parity based on Denise Williamson"Exchange rate policies in Peru, 1971-1979", a paper prepared for the conference on the "The Crawling Peg: Past Performance and Future Prospects", Rio deJaneiro, October 1978; 1977 II - 1980 IV estimated on the basis of differential between domestic and U.S. Inflation. Source: IMF, Bank staff estimates.  - 10 - C. Strengthening of the Tax System 28. During 1977 and particularly during 1978, the Peruvian Government took a number of measures to increase tax revenues. Under the Program Loan, the Government committed itself to take further measures to broaden the tax base, make the system more equitable, and improve tax administration. Technical assistance was financed under the Program Loan to help meet these objectives. (See Section IV, 5 of this report). 29. During 1979 and 1980, the Government strengthened tax administration so as to increase revenues, eased the income tax burden on low income strata and provided additional investment incentives. In general, the tax measures taken were very effective in increasing tax revenues. The buoyancy of the tax system with regard to GDP growth increased from an average of 1.0 during 1974-77 to 1.29 during 1977-80. The buoyancies for 1979 and 1980 were 1.31 and 1.33, respectively. The measures were, however, less effective in rationalizing the system and in making it more equitable. The overall incidence of the measures taken between 1975 and 1979 was slightly regressive -- in a system that already tended to be regressive. 2/ 30. Most of the measures implemented during 1977-78, represented increases in tax rates, particularly in taxes on goods and services. During 1979-80, more emphasis was given to improved tax administration. There were only few increases in tax rates, and most of the changes in tax rates were reductions and more generous deductions -- either to provide greater incentives to investment or greater equity. Judging, however, from the impressive improvement in buoyancy, the administrative measures were highly effective in increasing revenues and outweighed by far the losses resulting from reductions in tax rates. 31. A full account of the tax measures taken during 1978-80, prepared by the Central Bank of Peru, is available in the Division files. Among the administrative measures, those with the most significant impact on the system's buoyancy were the reduction of payment periods for the tax on goods and services, the increase in the installments of corporate income tax pay- ments from 1/12 to 1/8 of the previous year's tax liability, the automatic revaluation of assets including land, and the change of petroleum taxation from specific to ad valorem rates. The most significant tax increases were the higher taxation of rental income, the introduction of a windfall profit tax for mining companies, and the change in the income tax treatment of foreign petroleum companies from the privileged treatment under the "Peru Model" (with PETROPERU, the State-owned petroleum company, paying the companies' income taxes) to normal treatment (with the companies paying their own taxes). 32. The introduction of the new import tariff system in 1979, while reducing the unweighted average of tariff rates, resulted in slightly increased revenues because of the simultaneous reduction in tariff exemptions 2/ For an assessment of the incidence of tax measures taken during 1975-79, see Economic Report, No. 3438-PE, dated April 27, 1981, Annex III.  - 11 - and higher import volumes. The other changes in taxation were mostly reduc- tions: lower taxes of certain goods and services, elimination of the import surcharge, further reduction of tariffs, adjustments in the income tax scale basically in line with the increase in the minimum wage to keep lowest income from being taxed, and additional reinvestment credits for specific activi- ties. Some of these measures were designed to counteract the regressiveness of the tax measures implemented in previous years. The introduction of a two percent surcharge on corporate income in December 1980 and its earmarking for the newly set up nutrition fund stands out among the measures with progressive incidence. 33. In this context, improvements in Government pricing policies, although not falling under the committments made under the Loan Agreement, were partly the result of the dialogue associated with the Program Loan. During 1979, prices for publicly supplied goods -- mainly foodstuffs and petroleum derivatives -- were regularly adjusted. Prices for food were adjusted roughly in line with general price increases, and -- given somewhat declining international prices for some food imports -- subsidies were reduced. Prices for petroleum derivatives were adjusted at a rate substan- tially higher than average inflation, although they lagged behind inter- national price movements. During 1980, both the outgoing military Government and the newly-elected civilian Government, however, were reluctant to make the necessary price adjustments necessitated by the high rate of inflation. These lagging price adjustments led to rising subsidies and an increased public sector deficit in 1980. (Detailed price information is available in the Division files). The situation changed only when corrective price adjustments were made in January 1981. The Government eliminated most food subsidies. For petroleum, it intends to adjust prices gradually over a three-year period so as to approach international levels. For power and water, tariffs will be raised so as to generate sufficient cash to finance about one third of the planned investment. D. Interest Rate Policy 34. Under the Program Loan, the Government committed itself to regular interest rate adjustments to achieve positive levels in real terms during 1979. Interest rates had been raised substantially during 1978 and 1979 (for commercial bank lending from 17.5 to 32.5 percent), thus reducing the gap with regard to inflation of about 60 percent. They were kept constant there- after, until January 1981, when lending and deposit rates were raised to a nominal 49.5 and 50.0 percent, respectively. 3/ During 1979-80, nominal credit rates ranged from 31.5 to 32.5 percent, with some rates for credit to agricultural cooperatives, small-scale industry and mining at much lower levels; deposit rates varied between 29.0 and 30.5 percent. Taking standard two percent commissions and discounting practices into account, the effective credit rates in 1979/80 were on the order of 55 percent, but still substan- tially negative in real terms when compared to inflation of 67.7 percent in 1979 and 59.2 percent in 1980. Taking into account that interest payments on deposits are not subject to income tax, the effective deposit rates were also substantially higher depending on the applicable marginal tax rate. Yet, they also remained negative in real terms for all of 1979 and 1980. 3/ Compounding is done in a way so as to allow effective lending rates to exceed deposit rates by a substantial margin. Moreover, there are additional charges and other practices (like discounting) that raise effective lending rates.  - 12 - 35. The main argument made by the authorities during 1979-80 to justify not raising interest rates was that this would increase production costs and, therefore, further fuel inflation. The counter-argument that holding rates down resulted in financial disintermediation was taken lightly, especially since the banking system offered high-yielding dollar denominated instruments which attracted an increasing flow of financial savings. In summary, interest rate and pricing policies were the areas in which the Government deviated most from the ERP. However, the continued policy dialogue with the Belaunde Government has resulted in major improvements on both fronts. E. Public Investment Program 36. The 1979 Public Investment Program was supported by counterpart funds generated under the loan. In addition, the Government agreed to prepare an updated 1980-1982 investment program, which would give priority to projects selected on the basis of economic efficiency. 37. During its initial preparation mission in June-July 1978 the Bank identified two fundamental problems with the public investment program as it had been carried out during the previous few years and as it was being devel- oped for the 1979-1980 period. These were: i. Structure of the Investment Program - The program had given increasingly greater emphasis to directly productive sector activities, particularly in industry, which had yielded very little economic return to the country. At the same time, insufficient financing was provided for physical and social infrastructure in spite of the serious problems that were developing particularly in power, transportation, health and education. ii. Specific Projects - The public investment program in the 1970s included many large and ambitious projects with dubious economic justifications, which had been intended to build an industrial base for the country or satisfy regional demands. 38. During the course of preparation of the Program Loan, Bank missions worked closely with the Peruvian Government (principally the Planning Insti- tute (INP) and the Ministry of Economy and Finance (MEF) to reorient the public investment program toward badly needed infrastructure projects and away from large-scale projects with low returns and long gestation periods. In order to accomplish this, the following actions were taken: i. the Bank staff and the Government team identified specific projects, either under execution or about to be initiated, whose priority justified a substantial increase in funding. These included power sector operations (e.g. the Charcani and Restitucion hydroelectric projects and the Lima Mantaro trans- mission line); transportation projects (the Bank-financed Central Highway project, which was the only major road project under construction, and road maintenance operations); the Cobriza mining project jointly financed by the Bank and IDB, which had been stalled for lack of counterpart funds; and  - 13 - agriculture sector projects which were under way and promised a relatively quick return but which had also been delayed for lack of financing. These projects were identified as priority projects and given preference in the use of counterpart funds generated through the Program Loan to help ensure an adequate level of financing for 1979. ii. The Bank staff and Government team also identified projects whose economic justification was questionable or which-- because of their size, financing requirements and long gesta- tion period--did not appear to deserve priority, particularly at a time of economic crisis. These projects included the Majes irrigation and power project, the Cajamarquilla zinc refinery, Ilo copper refinery, SIDERPERU expansion program and the Olmos, Chavimochic and Puyango-Tumbes irrigation projects. Efforts were then made by the Government to reduce the scope of those projects in execution (primarily Majes) and to delay or abandon the projects which had not yet commenced. 39. The impact of the effort made to improve the quality and to rest- ructure the 1979 investment program was mixed. During the last half of 1978, the proposed 1979 Public Investment Program was substantially restructured from that contemplated in mid-1978. In the two years prior to 1978, produc- tive sector investment (much of which was in low return projects) absorbed 60-70 percent of total public fixed investment, leaving less than 20 percent for infrastructure and less than 10 percent for social sector projects. The initial 1978 public investment program reflected a continuation of this approach, with heavy emphasis on mining and large-scale irrigation projects. After revision of the program with Bank assistance, productive sector investment was reduced to under 50 percent of total investment while high priority infrastructure investments were increased to close to 30 percent. Social sector investment was increased from about 9 to 15 percent of total public fixed investment (see Attachment 2, Table 3). 40. The specific actions taken to accomplish these objectives were a substantial reduction in the funding budgeted for the Majes project, the elimination of the Ilo copper refinery expansion on the grounds that there was an insufficient supply of raw material; a substantial increase in the funding for transportation projects, particularly the Bank financed Lima-Amazon Transport Corridor project and road maintenance; and greatly increased financing for power sector projects. Thanks to the revision in priorities reflected by these actions together with the fiscal goals set under the IMF standby for 1979, all but one of the costly and questionable investment projects which pressure groups had been trying to introduce into the investment program were set aside. The one project that was introduced, the Cajamarquilla zinc refinery, ultimately absorbed a substantial amount of local resources (see Attachment 2, Table 4). It proved impossible to elimi- nate this project because supply contracts (which included substantial penal- ties) had already been signed and initial civil works begun. The Bank presented an analysis to the Government indicating that the project had a low economic rate of return. However, the sponsoring agency, MINEROPERIJr, had concluded that the financial rate of return would justify the project, since it was very power intensive and would be subsidized through power tariffs  - 14 - which did not reflect the marginal cost of power supply. MINEROPERU was, therefore, unmoved by the Bank's economic arguments, and the Government was unwilling to renege on its agreements with foreign suppliers and financing institutions. 41. At the time the Program Loan was presented to the Board in May 1979, the Bank believed that it had an agreed upon Public Investment Program which, aside from the Cajamarquilla Project and continued financing for Majes -- albeit at a reduced level -- represented a substantial improvement over past investment programs as a step to a more rational use of public resources in Peru. 42. Actual investment performance did not, however, meet initial expec- tations. The major problems derived from the Government's failure to accelerate infrastructure investment as rapidly as had been hoped while, at the same time, spending on Majes and Cajamarquilla exceeded the originally budgeted levels. As a result, the overall quality of the 1979 investment program was below that expected. Among the projects identified as having priority for purposes of receiving counterpart funds, some of the most important such as the Restitucion hydroelectric project and the Cobriza copper mine expansion absorbed less than half of the counterpart funds budgeted. The same was true for the Bank-financed PLANREHATIC project. It became apparent by late 1979 that serious project execution problems had to be resolved in the transport and power sectors - problems that were not amenable to correction in the short run. At the same time, the Majes project, which had a well established turnkey construction mechanism, was capable of absorbing substantially more funds than the Government had budgeted. The backers of Majes had sufficient influence to induce the Government to approve a supplemental budget to keep project construction at the level programmed by the Majes construction group rather than that foreseen in the budget. The same was true of Cajamarquilla, which was also a turnkey project. A total of $106 million, or about 16 percent of the total 1979 public investment program of $680 million, had been budgeted for these two projects; actual expenditures for the year were about $170 million or 25 percent of public investment. 43. Although by late 1979 the Bank was aware that there would be some distortion in the 1979 investment program, tentative figures indicating the extent of the problem were not available until the February 1980 supervision mission. By that time, there seemed to be little to be gained by withholding authorization to disburse the last tranche of the loan. Moreover, good progress was being made on several important components, especially trade liberalization and tax reform. The only clear violation on the public investment program was Majes, since the Bank had acceded to the inclusion of Cajamarquilla, whose accelerated completion would probably improve its economics. It was clear that for both political and legal reasons (see para. 45 below) there was little the Government could do about slowing Majes. The Bank, therefore, concentrated on insuring that a study of the rephasing of Majes would get started and that adequate funds were budgeted for priority projects in 1980. 44. In spite of these problems, the effort to reorient the 1979 invest- ment program laid the foundation for further improvements in 1980. Actual expenditures on productive investment fell to about 40 percent of total  - 15 - total public investment in 1980, while infrastructure investment rose to 34 percent as project execution problems were resolved. Social sector investment was still too low, primarily because of the limited execution capacity of the ministries involved. Total public investment increased by over 60 percent in U.S. dollar terms from 1979 to 1980, and the percentage of the investment program executed compared with that budgeted also increased from 81 to 83 percent in this period. These figures indicate an improving absorptive capacity, which -- to some extent -- was also reflected in the level of disbursement on Bank project loans which increased from US$22.5 million to US$26.9 million in the CY1979-1980 period. Expenditures on Majes and Cajamarquilla dropped to 18.5 percent of investment. 45. The Majes irrigation and power project -- a gigantic project with extremely low or even negative return -- deserves further mention, since much of the energy of the Bank staff was directed -- ultimately with only limited impact -- toward a reduction in the funding for this project. When it became apparent, during the course of 1979, that the Government could not slow the pace of project execution to accommodate the initial budget, an interim study was commissioned by the MEF and financed by the Program Loan to develop a rational basis for the 1980 budget allocation for Majes. This study was completed by the end of 1979 and, based on its recommendations, about $32 million was budgeted for the project in 1980. The study pointed out, however, that legally the Government was obliged to provide local counterpart funding for Majes based upon the construction program set by the foreign turnkey contractors. If it failed to do this, the foreign financing agencies (mostly bilateral and commercial bank sources from the five countries whose contractors were building the project) could accelerate their loans. Therefore, the interim Majes study recommended a legal analysis of the contracts leading to their renegotiation as the only solution to getting control over Majes. Meanwhile, a more complete analysis of the project was commissioned by MEF and financed by the Program Loan as a basis for the possible rephasing of Majes to optimize its benefits. This study was completed by March 1980 but the Government failed to follow through with the legal analysis. Expenditures on Majes for 1980 reached the level of almost $100 million, compared with the $32 million budgeted. Although the Belaunde Government, which took office in mid 1980, completed the legal analysis and is considering modifications of the Majes contracts, it was very late to change the construction phasing to make it more economically efficient. 46. Since in 1979 the decision had been taken to hold elections in early 1980, the outgoing Government did not undertake preparation of a 1981-1982 investment program as provided for in the ERP, leaving this matter for the consideration of the new Government. The Program Loan subsequently financed technical assistance to help prepare a revised 1981-85 investment program, and the Bank was closely associated with this effort since it was prepared for the May 1981 Peru Consultative Group. The advances made in improving the quality of public investment in 1979 and 1980 were continued in this program. With the economic and financial improvement of 1980, pressure again began to be exerted on the Government to undertake large and costly new projects without sufficient technical and economic analysis. The Consulta- tive Group Meeting provided a framework for holding these forces at bay, and the Bank is now exploring with the Government the possible creation of addi- tional safety mechanisms to insure the application of rational criteria in the selection of public investment projects.  - 16 - IV. EXECUTION OF THE PROGRAM LOAN 1. Loan Withdrawal 47. The disbursement schedule provided for in the Loan Agreement (see para. 13) was not maintained. Prior to Board presentation of the Program Loan and for the balance of 1979 an 1980, Peru's foreign exchange situation improved substantially. During 1978, when there was a shortage of foreign exchange, commercial Banks had to apply to the Central Bank for a foreign exchange allocation to meet their needs. As foreign exchange became more readily available, the commercial banks were in a position to satisfy their foreign exchange requirements without resorting to the Central Bank. As a result, the Central Bank was unable to disburse Program Loan foreign exchange through the commercial banks, and disbursements through December 31, 1979 amounted to only $26.5 million, compared with the $100 million expected. 48. To deal with this situation, the Central Bank took a number of measures to increase the demand for foreign exchange, and it made informal arrangements with the commercial banking system for utilization of Program Loan funds. Also, the list of eligible imports was expanded. These efforts ultimately resolved the problem. By March 31, 1980, disbursements had reached $70 million and were over 95 percent complete by the original closing date of June 30, 1980. There was need for an extension of the closing date beyond June 30, 1980, as a result of the slow start up of disbursement, and also to allow for completion of the technical assistance program financed under the loan, which had moved more slowly than expected (see para. 62 below). The program of imports was substantially completed by September 1980 when disbursements reached $114.3 million and the undisbursed balance of approximately $700,000 represented the maximum amount the Bank and the Government felt might be needed for technical assistance. In November 1980, the closing date was formally extended to December 31, 1980, with the understanding that the Bank would be prepared to continue disbursements into 1981 in order to permit completion of the technical assistance program. The final disbursement of the Program Loan was made on July 15, 1981, after all technical assistance had been completed. 2. Use of Loan Proceeds 49. The following table indicates the originally proposed and actual allocations of loan proceeds:  - 17 - Table 5: PLANNED AND ACTUAL LOAN ALLOCATION US$ million Goods to be Amount as per Actual Amount Category Financed Loan Agreement Disbursed 1-a Manufacturing Industries Sector 95.0 105.0 1-b Other Sectors 19.9 9.8 2 Technical Assistance 0.1 0.2 T 0 T A L 115.0 115.0 As may be seen, the most significant variation in the actual pattern of disbursements was the expenditure of$10 million more for manufacturing industry imports and a reduction of approximately $10 million in imports for other sectors. Also, actual expenditures for technical assistance amounted to over $200,000, compared with the original $100,000 estimate (see para. 62 below for a discussion of this). The allocation in the Loan Agreement for the financing of eligible imports simply reflected a rough estimate of potential demand during the 1979 period. The variation in the distribution of goods actually financed was not significant, nor did it have any bearing on the achievement of loan objectives. 50. The variation in the amount of industrial as opposed to "other" imports financed probably stemmed from two modifications made after loan approval. When it became apparent in mid-1979 that disbursements were moving slowly, the Bank and the Government agreed to expand the list of eligible imports. The original list of imports for the industrial sector had focused primarily on inputs for manufactured exports. Although one objective of the ERP was to increase non-traditional exports, the broader objective was economic reactivation. There was no objection to adding additional goods to the list if it would help accomplish this purpose. The Bank, therefore, agreed to include, as eligible imports for Program Loan financing, industrial inputs for products sold primarily in the domestic market. 51. A modification was also made in Program Loan procurement procedures (See para. 52), which affected the utilization of loan proceeds. Under the Loan Agreement, loan proceeds could only be used to finance goods purchased by private importers. Again, in order to spur disbursements, in February 1980 the Bank agreed to permit the financing of eligible imports purchased by the Empresa Nacional de Comercializacion de Insumos (ENCI), a State-owned purchasing agent for such goods as fertilizers and grains used in industrial processes in Peru. These goods were already eligible imports under the loan. In total, approximately $16.5 million of ENCI's imports were financed under the loan, with 75 percent of these for the industrial sector. The ENCI imports taken together with the 1979 expansion of permitted industrial imports explain, in large part, the $10 million increase in actual industrial imports.  3. Procurement 52. Because Program Loan proceeds were intended to finance only private sector imports, normal commercial procurement practices were permitted. Only contracts of over $5 million were required to be awarded on the basis of international competitive bidding. Since no contracts of this amount were financed, ICB was never used in connection with the loan. There were two other procurement procedures used: (i) Goods for the health sector-Because PAHO had an established and efficient purchasing mechanism, it was able to buy in bulk at low prices. It was, therefore, agreed that all health sector imports would be procured through PAHO. This system appears to have functioned well (see Section 6 below). (ii) ENCI imports-The Bank agreed to accept ENCI's procurement procedures although these did not meet the Bank's ICB requirements, since the Procurement Advisor concluded that they were designed to assure the lowest possible purchase price for the type of goods which ENCI purchased. The mechanism, through which this was accomplished, was a two-stage price quotation procedure under which ENCI, within a short and stipulated time period after the initial price quote would go back to the lowest bidders on its contracts for an improved price quotation. 4. Use of Counterpart Funds 53. The Loan Agreement provided that counterpart funds generated by Program Loan disbursements would be used to finance priority investment projects in the 1979 budget. The basis for selection of these projects, as well as overall performance has been discussed above (see paras. 36-38) 54. The funds were allocated to agriculture and fishing (15.7 percent), mining (3.2), industrial credit and tourism (6.6), power (11.2), transport (39.4), education (4.4), and health, water, and urban development (19.5). Allocations to specific projects followed the indicative list of Schedule 6 of the Loan Agreement; they are presented in Attachment 2, Table 1. 55. This assignment of counterpart funds to specific projects was done at the request of the Peruvian Government. Government officials felt that the restriction on the use of budget resources which was imposed by this arrangement would be a useful mechanism to help ensure approval of the 1979 investment program as it had been agreed with the Bank. Without this restriction, they feared that political pressure might result in increased financing for lower priority projects. As discussed above, the actual execution of the 1979 investment program resulted in higher allocations to low priority projects. This showed the relative ineffectiveness of the budget as a control instrument. Nevertheless, the assignment of counterpart funds generated by the Program Loan to specific projects was a useful device in preventing the addition of new projects of low priority and probably helped make available more resources for certain projects (e.g. road maintenance, irrigation rehabilitation, and power projects) than might otherwise have been the case. 56. According to the Central Bank accounting, disbursements for eligible imports amounted to $111.7 million and generated a total of S/.29.5 billion in counterpart funds. Although only $26.5 million of this was disbursed in 1979, the total sol-equivalent was credited to the 1979  - 19 - investment budget as foreseen in the Loan Agreement. Total allocations to priority projects amounted to S/.32.6 billion or about 10 percent more than available counterpart funds. Table 1, Attachment 3 shows the distribution of counterpart funds among the priority projects and Table 4, Attachment 3 shows the total level of expenditures for the priority projects receiving counterpart in 1979 and 1980. 5. Technical Assistance Background 57. The Program Loan included an allocation of $100,000 to finance a technical assistance program for the following purposes: (i) to design a tax enforcement program; (ii) to revise import tariff structures; and (iii) to carry out other tasks related to the ERP or the project. Based on the definitions of the "project" and the "ERP" contained in the Loan Agreement, this last clause gave very broad scope to the technical assistance that might be financed by the loan. 58. The following is the breakdown by subject area of the technical assistance contracted with Program Loan financing: Table 6: TECHNICAL ASSISTANCE PROGRAM Amount Subcomponent Disbursed (US$) a) Trade liberalization 32,400 b) External debt management 9,200 c) Tax administration and enforcement 36,860 d) Income and employment policy 11,664 e) public investment program evaluation: i) Majes project 55,886 ii) Bayovar project 37,055 iii) automotive sector investment program 30,000 iv) 1981-85 public investment program 21,450 Total 234,515 General Problems 59. During the execution of the Program Loan, the Bank became increasingly aware that the broad definition of possible technical assistance left a wide scope to the Peruvian Government to propose studies. The economic team with which we were dealing included a number of talented and creative people and, at times, they developed technical assistance proposals which, although arguably within the definition of the Loan Agreement, did not appear to deserve high priority. Ultimately, the proposals fell through but not before a substantial amount of time and energy were spent in discussing and defining them.  - 20 - 60. Another problem that became apparent even before the loan was approved was the Peruvian Government's lack of flexibility in regard to hiring consultants. Because civil service salary limitations applied to individual consultants, the Government was not in a position to pay competitive salaries for foreign and, in many cases, even for local consul- tants. In addition, the Government's procurement regulations required a competition for hiring the services of consulting firms. Such competitions are time consuming and difficult to administer properly because of the lack of objective criteria for selection. These problems arose immediately with the consultant hired to advise the Government on the design of a tax enforce- ment program. Ultimately, the consultant had to be hired by the Bank on the condition that the Government would reimburse the Bank out of the loan. We viewed this device as a stopgap measure since, in most cases, it would have been inappropriate for project consultants to be contracted directly by the World Bank. The makeshift solution which was adopted thereafter to avoid the problem was to have the Bank contract consultants acting in representation of the Peruvian Government. Although the Government was satisfied with this arrangement, neither the Program nor the Personnel Department was happy with it, as it came too close to direct Bank contracting. We, therefore, urged the Government to find a mechanism to directly contracted consultants. Finally, an arrangement was worked out whereby consultants were contracted by the Central Bank, which is not subject to central government salary or procurement requirements. This procedure, however, was not put in place until April 1980 and, in the meantime, the Bank was forced to follow an unsatisfactory procedure, which caused additional work for the staff. 61. As a result of these two problems, the Programs Division found itself spending more time and energy than anticipated on managing the execu- tion of the technical assistance component. Nevertheless, it shared the Government's assessment that the technical assistance made a valuable contribution to the definition of a number of major components of the ERP. Expansion of the Technical Assistance Program 62. During the execution of the Program Loan, the Bank agreed to an expansion of the technical assistance program and, ultimately, to an exten- sion of the closing date to allow for its completion. Some of the most important work, i.e. advisory services on tax enforcement, trade liberaliza- tion and an initial evaluation of the Majes project were begun promptly in 1979 -- the tax assistance under retroactive financing prior to Bank approval of the Program Loan. This work, however, only accounted for about 30 percent of the technical assistance ultimately contracted. By early 1980, the Bank had concluded that with the coming change of Government in July 1980, it would be useful to have funds available for technical assistance to support development of the new Government's economic policy. We felt that making such financing available would not only be useful for the Government but would help in establishing a strong economic dialogue with the incoming administration. After early 1980, therefore, we did not press the Government to identify possible additional technical assistance. By extending the closing date of the Loan to December 31, 1980, and informally to July 15, 1981, the Bank was able to help finance technical assistance for the new  - 21 - Government on external debt, income and employment policy, preparation of the 1981-85 investment program and an evaluation of the Government's partici- pation in the Andean Pact automotive industry program. 63. Technical Assistance Contracts a) Trade Liberalization: Under this category, the Bank financed two Peruvian nationals who worked as advisors to the Ministry of Industry, which at that time had responsibility for foreign trade matters. Both these consultants provided advisory services to the Ministry on the restructuring of Peru's tariff system, the elimination of administrative restrictions on imports and on the promotion of foreign trade. The results of this technical assistance were highly satisfactory and provided the basis for the Government's trade liberalization program. The consultants had substantial influence on Government policy, and, subsequently, the trade liberalization program was extended beyond the scope originally contemplated under the ERP. b) Tax administration: Advisory services to improve tax adminis- tration were provided by a consultant prior to the approval of the Program Loan and also by the Interamerican Center of Tax Administration (CIAT). The consultant assisted in the devel- opment of a tax enforcement program. He did not prepare written reports but drafted legislation and administrative reforms that made possible modifications in procedures and policies. His task was made particularly difficult owing to the lack of cooperation by the National Tax Administrator who was opposed to the objectives of the reform and to the prin- ciple of assigning a foreign consultant to his office. Never- theless, his work led to some important innovations, particu- larly in the area of urban real estate taxation. His services ended in April 1979. The other tax assistance program, that provided by CIAT, laid the basis for the restructuring of tax administration, the utilization of more modern techniques and methods of tax administration and improvements in auditing procedures. c) External debt management: This assistance was provided to the Central Bank by a Peruvian national who was on leave from the IMF. The terms of reference called for assistance in debt management at the Central Bank. Yet the Authorities were not prepared at that time to shift responsibilities for debt management from the Public Credit department in the Ministry of Economy and Finance to the Central Bank, thus leaving the assistance program without a meaningful addressee. In the absence of clear Central Bank authority in this field, the consultant concentrated on methodological improvements in the Central Bank's balance of payments statistics, particu- larly in the capital account. The consultant's contributions  - 22 - on this particular topic were useful. However, debt manage- ment still needs strengthening. Although, the assistance under the Program Loan failed to achieve the desired result, the continued policy dialogue, started under the Loan, began to bear fruit: important changes were made in the organiza- tion of debt management, and a technical assistance loan to strengthen public sector management includes a component to strengthen this process. d) Income and employment policy: This assistance was provided by a Peruvian national, who advised the Ministry of Labor on the social impact of economic policies, the design of income and employment policies to minimize the negative distributional impact of economic measures and the identification of vocational training programs to increase employment. The Program Loan financed only a small portion of the consultant's assignment. Additional financing was provided later on by the ILO. The consultant started an important program to collect and analyze highly disaggregated information on wages and salaries, employment, and productivity to support the Government's efforts to implement a stabilization and equity oriented incomes policy through a Tripartite Commission composed of the Government, the unions, and associations of entrepreneurs. The program is still under way, and it is too early to evaluate the outcome. e) Strengthening of the public investment program: (i) Majes - the details of the technical assistance provided on the Majes project and its results are discussed in para. 45 above. One further aspect of this assistance deserves mention. The evaluation of the Majes project by an objective outsider was a major element in sensitizing both the Peruvian Government and the general public to the gravity of the Majes problem. Although, ultimately, the Government could not put into effect the consultant's recommendations, the knowledge of the economic damage that could be done by projects such as Majes seems to have strengthened the Government's resolve to resist other similar proposals now being pushed (e.g., the Olmos and Chavimochic projects). The consultants on this component did an excellent job, politically as well as technically, in proposing a revision of the Majes project. (ii) Bayovar - the Bayovar phosphate fertilizer project,whose cost may range between $700 and $900 million, was being studied under a bilateral agreement which gave an industrial agency of the country involved rights to participate in the project. The industrial agency's report was delivered to the Government in 1980 and suggested that substantial fiscal subsidies were necessary to make the project viable and would, therefore, be required as a condition of its participation.  - 23 - The Government consulted with the Bank on the results of the study and Bank staff suggested that the project might be reformulated to make it economically attractive without the provision of Government subsidies. The Bank suggested the hiring of several consultants to work on an initial reformula- tion. Ultimately, the Peruvian Government sought a Bank engineering loan to finance its own feasibility study of the project. This study is now close to completion and indicates that the initial Bank judgment was correct. The technical assistance financed by the Program Loan was instrumental in averting a major public investment mistake which might have proven very costly to the Peruvian economy. (iii) Review of the automotive sector - Under the Article 20 of the Cartagena Accord, Peru was assigned development of certain elements of the Andean Group's automotive program. During the 1970s, the Peruvian Government had entered into a series of joint ventures to carry out its automotive invest- ment responsibility. None of these projects, however, have proven to be either economically or financially justified, and the newly installed Belaunde administration requested Bank assistance for an urgent review of the automotive program with the objective of proposing a reformulation of Peru's responsi- bilities. The consultants hired for this purpose and provided a satisfactory proposal to the Peruvians for presentation to the Andean Group. (iv) 1981-85 Public Investment Program - Upon taking office the Belaunde administration was confronted with the need to quickly prepare a revised five-year public investment program reflecting its policies and objectives. The Government requested that the Bank schedule a Consultative Group Meeting for mid-1981, which left little time to prepare and approve the required investment program. In order to meet the poli- tically critical objectives of putting an investment program in place and of presenting it to the international financial community, the Government contracted a local consulting firm to support the National Planning Institute, which has primary responsibility for preparing the investment program. The firm provided additional manpower which made it possible to present to a May 1981 Consultative Group Meeting a five-year public investment program which will provide the basis for the Government's future development efforts. 6. Health Component 64. Peru's economic situation in the late 1970s greatly affected the resource allocation to health services. In March 1979, a Bank mission  - 24 - appraised a Government proposal to finance high priority inputs for communicable disease control programs to avoid a collapse of their opera- tions. Funding under the Program Loan made possible the purchase of necessary drugs, vaccines and insecticides to operate the control programs for tuberculosis, malaria, chagas, and immunization of preventable diseases. 65. The health component of the Loan totaled $2.7 million, disbributed as follows: $0.85 million for immunization programs; $0.9 million for malaria control; $0.22 million for chagas control; and $0.73 million for TBC control. 66. Procurement of drugs, vaccines and insecticides was done on behalf of the borrower by PAHO (Pan American Health Organization) under a letter agreement with the Central Bank of Peru and Ministry of Health. PAHO can purchase these health inputs in large quantities and at lowest prices in the market because of its U.N. international mechanisms. This arrangement greatly improved the timely availability of health inputs. 67. The Program Loan health component made it possible to maintain and in some cases improve the population coverage with control activities, (health statistics for the 1979-81 period are available in Division files). During the two years of program implementation, the number of detected malaria cases were much less than those expected and show a decreasing trend of detected cases, which coincides with a decreasing rate of positive blood samples -- from 10.3% in 1979 to 8% by August 1981. The immunization program barely maintained the same vaccination coverage during 1979 and 1980 with the inputs received from the Program Loan health component. Some of the reasons for this were delays caused by administrative red tape in customs clearance of refrigerators for the cold chain which restricted vaccination activities, especially in rural areas and lack of personnel to administer the program. The tuberculosis control program achieved important improvements in the diagnosis and treatment of suspected cases with the input provided through the health component. The more timely availability of drugs and the use of a new treatment schedule reduced the drop-out of patients under treatment from 50% to 12%. Evaluation of prevalence trends is only possible after 4-5 years of the new treatment schedule. V. CONCLUSION 67. The Program Loan's main objective was to support the Government's ERP, which entailed major policy changes in such critical areas as import liberalization, export promotion, exchange rate policy, interest rate policy, tax administration, and reorientation of public investment. This objective was achieved to a high degree, particularly in the trade area (import liberalization, export promotion). Beyond the immediate and measurable results, the Program Loan provided the Bank with an excellent opportunity for a far-reaching and frank policy dialogue, which covered a broad spectrum of policy issues. This dialogue--based on periodic monitoring of economic performance--has continued with the Belaunde administration and has created an atmosphere of mutual trust. The opening of the Bank's resident mission in December 1979 has also had a major positive impact.  - 25 - 69. As spelled out in the report, the Loan was less successful in some other areas as pricing and interest rate policies, and the impact on the public investment program was also limited. However, based on the continued policy dialogue, progress has been made in these fields after the formal completion of the Program Loan. Major upward adjustments of prices for publicly supplied goods and services have been implemented at regular intervals, the interest rate structure was revised and substantially raised, and the Bank's involvement in public investment planning through the May 1981 Consultative Group and through Bank staff participation in recent IMF missions is showing more positive results, i.e. some new major projects of doubtful economic justification have been held in abeyance pending the results of additional studies. Even with regard to the Majes project the Government now seems to be willing to take some corrective action. 70. The technical assistance and health components were also largely successful. The technical assistance was instrumental in engineering the import liberalization process and in the reformulation of the Bayovar phosphate project; it also made a major contribution to the Government's thinking process on public investment through the Majes study and the preparation of the 1981-85 investment program. The purchase of drugs, vaccines, and insecticides under the health component also reaped measurable positive results in some areas, which was particularly important during a time of economic stabilization with substantially reduced public health expenditures and rising incidence of communicable diseases and infant mortality.  Attachment 1 - 26 - Page 1 of 2 SCHEDULE 5 Economic Recovery Program The Economic Recovery Program includes: (1) the Borrower's stabilization program as published in "E1 Peruano" dated September 23, 1978; (2) the restructuring of portions of the Borrower's public and private external debt in accordance with the Paris Club Agreement of November, 1978; (3) the adoption of non-traditional export promotion poli- cies, new import liberalization policies and elimination of quantitative import restrictions, including: (a) elimination of the items included in the temporary list of import restrictions established by the Borrower's Decreto Supremo 005-79-ICTI/DM and Resoluci6n Ministerial 173-79-ICTI/CO-SE with approximately 25 per cent of the items to be eliminated by June 30, 1979 and an additional 25 per cent each semester thereafter until December 1980 when the list will be entirely eliminated; (b) gradual broadening of the Borrower's Lista de productos susceptibles de importaci6n (Permitted Imports List), to be carried out simultaneously with (a) above; (c) continued automatic granting of import licenses for products on the Permitted Import List; (d) preparation by June 30, 1979, of a proposed new imports tariff law the structure and levels of which will take, as a guideline, Proposition 96 of March 29, 1978 of the Commission of the Cartagena Agreement; (e) enactment by July 31, 1979 of a new imports tariff law and gradual implementation of its provisions leading to full adoption by December 1983, accor- ding to a calendar to be prepared by July 31, 1979;  - 27 - Attachment 1 Page 2 of 2 (f) gradual elimination of import tariff exemptions to be completed by December 1980; and (g) the continuous adjustment of the exchange rate, by means of mini-devaluations of the Borrower's unit of currency, in order to maintain a real (or approximately real) parity of such rate; (4) the strengthening of the Borrower's tax system, inclu- ding: (a) adoption by December 1979 of measures in addition to those adopted prior to February 1, 1979 to broaden the tax base and improve the equity of the tax system through inter alia reduction of tax exemptions and exonerations; and (b) the adoption of measures (to be taken progressively between the date of this Agreement and Septem- ber 30, 1979) to improve tax administration and control of tax evasion, and the provision to the Borrower's Direcci6n General de Contribuciones (hereinafter called DGC) of the resources required for the purpose (including funds additional to those allocated to DGC in the Borrower's budget for 1979). (5) the periodic adjustment of the interest rates applicable in the Borrower's territories, insofar as periodic assessments should show such adjustment is necessary, in order to achieve in 1979 and maintain thereafter effective interest rates at positive levels in real terms; (6) carrying out of the projects included in the 1979 Investment Budget giving preference to those projects receiving funds from the Project Account; and (7) the preparation of an updated 1980-82 investment program which will give priority, principally, to projects selected on the basis of economic efficiency.  - 28 - Attachment 2 Table 1 Table 1: ALLOCATION OF COUNTERPART FUNDS TO HIGH PRIORITY PROJECTS IN THE 1979 INVESTMENT BUDGET (Actual Project Execution) Millions Sector and Project of Soles % Agriculture, Fishing 5,124.7 15.7 Tinajones Irrigation 1,081.0 3.3 Planrehatic 523.0 1.6 Chira-Piura Irrigation 571.2 1.6 Palm Oil Plantation 475.0 1.5 Agricultural Bank 2,200.0 6.7 La Puntilla Fish Complex 155.5 0.5 Fish Terminals and Freezing Plants 173.0 0.5 Mining 1,056.6 3.2 Cobriza Copper Mine 945.3 2.9 Mine Water Treatment Plant 111.3 0.3 Industry, Tourism 2,168.0 6.6 Industrial Bank 800.0 2.4 COPESCO Tourism Development 1,368.0 4.2 Power 3,643.4 11.2 Mantaro Hydro Project 805.5 2.5 Restitucion Hydro Project 78.4 0.3 Canon del Pato Hydro Project 1,431.9 4.4 Charcain Hydro Project 131.8 0.4 Regional Electrification Schemes 596.1 1.8 Miscellaneous Projects 599.7 1.8 Transport 12,835.6 39.4 Highway Maintenance and Rehabilitation 4,092.0 12.6 Oroya-Huanuco Highway 1,477.9 4.5 Huanuco-Aguaytia Highway 2,258.0 6.9 River Ports 404.0 1.2 Bridge Construction 1,436.3 4.4 Airport Infrastructure 1,118.5 3.4 Regional Road Construction 1,838.9 5.7 Other 210.0 0.7  - 29 - Table 1: (continued) Millions Sector and Project of Soles % Education 1,437.3 4.4 Education Reform 644.5 2.0 Construction and Equipment Credit 192.8 0.6 National University System 600.0 1.8 Health; Water; Urban Development 6,350.2 19.5 National Urban Water and Sewerage Program 3,378.9 10.4 National Institute of Health 95.4 0.3 Hospital Construction and Maintenance 1,018.5 3.1 Mantaro Transfer (Engineering) 357.4 1.1 Housing Bank 1,500.0 4.6 Grand Total 32,615.5 100.0 ====== ==== = = ===  - 30 - Attachment 2 Table 2 Table 2: CENTRAL BANK ALLOCATIONS (own funds) Millions of Soles To 1979 1980 BAP 6,233 26,810 BIP 8,097 5,000 of which FENT 6,400 2,000 All figures are net flows Source: Central Bank (7/2/81) The figures may be used to put the allocation of counterpart funds to these institutions into context.  Attachment 2 - 31 - Table 3 Table 3: 1979 - 1980 PUBLIC FIXED INVESTMENT BY SECTOR 1979 1980 US$ Millions US$ Millions Budget Budget Execution Execution Sectors Budgeted Actual % Budgeted Actual % Productive 403.3 366.5 91.0 548.8 455.0 82.9 Infrastructure 285.1 184.2 64.6 466.9 375.3 80.4 Social 125.6 115.9 92.3 247.5 197.4 80.0 Other 30.3 15.5 51.2 86.4 88.9 102.9 T 0 T A L 844.3 682.1 80.8 1349.2 1116.6 83.0 % of GDP 5.5 4.5 - 7.0 5.8  - 32 - Attachment 2 Table 4 Table 4: LARGE SCALE INVESTMENT PROJECTS 1979 1980 US$ Millions US$ Millions Projects Budgeted Actual Budgeted Actual Majes 37.5 57.6 31.9 96.8 Cajamarquilla 68.5 111.3 77.9 109.6 T 0 T A L 106.0 168.9 109.8 206.4 % of Public Investment 24.8 19.2  - 33 - Attachment 3 COMMENTS FROM THE BORROWER Page 1 of 3 25356PE COFIDE IaB IU3 2G 9:13 TLX 074-1/82-15 25.08.82 WORLD BANK WASHINGTON U.S.A. ATT.: MR. SHIV S. KAPUR AAA) ACKNOWLEDGE RECEIVING YOUR LAST LETTER REGARDING PROJECT PERFOMANCE REPORT IN PERU LOAN (NRO. 1693-PE) BBB) WE FIND THE DRAFT REPORT SATISFACTORY REGARDS FELIPE ORTIZ DE ZEVALLOS  FORM ..0. 788 L (1-74) IBRD IANGUAGE SERVICES D CONTROL No. E-479/or IDATE: 16 November 1982 ORIGINAL LANGUAGEt Spanish (Peru) DEPT, LACT ITRANSL DS Jb REV: JCB COMMENTS FROM THE BORROWER - 34- Attachment 3 Ministry of Health Page 2 of 3 Lima, Peru October 15, 1902 Mr. Shiv S. Kapur Director, Operations Evaluation Department The World Bank Washington, D.C. Reference: Program Loan I am pleased to let you have the Ministry of Health's comments on the points made in the World Bank's Project Performance Report. 1. The Ministry of Health received two successive tranches of financial assistance in 19(9-oO from the World Bank, totalling US$2.7 million, to help carry out the Malaria Vaccination and Control and Tuberculosis Control Program, the funds being specifically earmarked for the purchase of DDT and Gamexano and also of anti-tuberculosis drugs, these being duly purchased and distributed throughout all the regions of the country. 2. These supplies were purchased through PAHO, mainly in order to speed up procurement, but this plan did not prove completely successful for a variety of reasons. 3. The control of diseases preventable by immunization improved slightly in terms of protection coverage. The protection rates achieved for the susceptible population against measles and tuberculosis were 22% and 55%, respectively. Coverage was not so good as regards protection against dirhtheria,whooping cough, and polio in all of which cases a series of three immunizations is required. This problem was primarily due to the absence of any cold-storage network and to the shortage of health services and trained manpower, particularly in the rural areas where the population is generally scattered.  - 35 - Attachment 3 Page 3 of 3 4. There was a high incidence of malaria in 1977 and 1978, with as many as 117 and 195 cases per 100,000 inhabitants. During the following years, which coincided with World Bank assistance, the decline in the incidence of malaria cases was due to inefficient reporting rather than to any real lessening of the problem. This failure to report cases originated in new settlements that sprang up around the oil-fields and were certainly the source of new cases because they were located in malarialareas. 5. With regard to tuberculosis control, World Bank assistance, which made it possible to purchase drugs for standard and short-course treatments, did help achieve greater efficiency in the treatment and arresting of tuberculosis. From an epidemiological point of view, however, the impact was minimal because the magnitude of the problem actually increased, due quite certainly to other factors, socio-economic conditions in particular. I would appreciate it if you would take these comments into account in drawing your final conclusions. Yours etc. /s/ Dr. Juan Franco Ponce Minister of Health